The techtonic shift’s doubters just can’t count cash

I keep hearing about tech companies which don’t make any money. Ocado posted a loss. As did Tesla, Uber, WeWork, and so on.

“It’s a bubble,” the sceptics scream. Over and over and over again, for quite a few years now.

But anecdotal evidence has a habit of hiding the real trend instead of showing it off.

There may well be tech stocks going up that don’t make money. But that doesn’t mean tech stocks generally aren’t making money as they go up.

According to this chart, those money-losing tech stocks I mentioned are the exceptions that prove the rule.

Source: The Market Ear

It looks like tech companies are the ones delivering profits for the stockmarket, not holding them back…

And tech stock prices are outperforming as a result. CNN points out just how much:

The five largest companies in the S&P 500 — all tech companies — account for nearly 20% of the market value of the entire index. Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Google owner Alphabet (GOOGL) and Facebook (FB) are collectively worth $4.85 trillion. The S&P 500 (SPY) has a market value of around $26.7 trillion.

Four of those tech companies are responsible for the bulk of the S&P 500’s return in 2019 and three for the decade.

Source: MarketWatch

The people who bemoan money-losing tech stocks need to check their overall maths, not just list the tech stocks that aren’t making money yet. Tech is dominating stockmarket earnings and returns too, if you count broadly. The tech boom is real. And it’s cash-flow positive.

In other words, it’s been a great time to be a tech investor. In the US, anyway. Here in the UK, the fintech sector is particularly active too. UK markets are home to plenty of other unicorn stocks.

The sceptics aren’t completely wrong though. Just take a look at that first chart again. The last time tech stocks led earnings growth like this was during the tech bubble of 2000. After which they underperformed, to put it mildly.

So the story is a little more complex than it seems. What’s the real takeaway?

I mentioned it yesterday. It’s all about cash flow. For some reason, tech investors love to abandon the rules that are important to investing. They think tech is different and cash flow doesn’t matter. Even though they don’t have to believe that to be a tech investor.

Tech companies with bright prospects are highly risky until they break even at least. The best tech stocks to buy are ones that crossover into profits. Then you get the best of both worlds – potential and cash flow.

This company is a prime example.

Cash flow is especially tough to fake, making it a great filter for dodgy accounting. And cash is what repays debts and provides further funding – the lifeblood of tech stocks.

But even cash flow can lead you astray. You might still overpay for the prospects of the company. The best way to avoid that is called the price/earnings ratio (P/E).

Think of it as the amount of money you’re paying per pound of annual earnings. A P/E of 10 is like paying £10 for a stock that earns £1 per year in profits. Which is a rather rosy scenario for any company that will grow. P/Es of 25 or more are the norm in tech.

Tech stocks tend to have high P/Es because future earnings are expected to grow rapidly. But money-losing tech stocks don’t have a P/E at all. For a simple reason.

Back at university, my friends and I completed a financial analysis assignment together. We financially analysed listed Aussie wine companies. Unfortunately, none of them made a profit. And so most of the ratio-driven financial analysis we were supposed to write about didn’t really make sense. Denominators of less than 0 and that sort of thing.

We still got top marks by dressing up in togas and playing UB40’s “Red Red Wine” for our class presentation…

Most investors would incorrectly conclude from my story that when a company isn’t making money, it pays to get up and dance. But the wine stocks ended up falling quite far. And so I’d conclude the opposite. Cash flow is just as important to tech investors. A high P/E ratio is better than no P/E, as any Excel spreadsheet will warn you.

I hope today’s Exponential Investor has shown that there’s plenty of that cash flow in the tech industry today, and it’s leading to gains in stock prices. You don’t need to give up on corporate profits to be a tech investor.

But what of the rest of the market? You might think non-tech stocks are boring. And you’d be right, in terms of earnings. I mean, look at how earnings have progressed for non-tech companies in our first chart. They’re barely back to 2008 levels! And tech bubble worriers criticise tech stock earnings…

Those in glass houses shouldn’t throw stones, eh?

Until next time,

Nick Hubble
Editor, Southbank Investment Research

Category: Commodities

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